FINA3324 Investment Analysis Semester 1: 2022

Week 1: God’s Work

Introduction

In 2010, John Cassidy wrote in The New Yorker that “for years, the most profitable industry in
America has been one that doesn’t design, build or sell a single tangible thing”1. Cassidy was
referring to the finance sector. The US experience is not exceptional. Finance thrives in the
UK as well where it contributes 10% of the UK’s total economic output, employs 2.3 million
people, is the largest tax payer and is the country’s biggest exporting industry2. In Australia,
the finance sector contributes around 8% of total GDP, behind health and education (13.2%)
mining (11.5%)3 and employs over 800,000 people which is about 6% of the total number in
employment4.
It’s curious phenomenon that whilst contributes significantly to the economy the reasons
finance is a thriving sector of the economy is a puzzle, even scandalous, to many people.
Cochrane’s article included in its headline the claim that “much of what investment bankers do
is socially worthless”.
In Week One we address four questions.
1. What use is finance?
2. What kind of work does finance involve?
3. Why is finance profitable?
4. Why is finance often ethically challenging?

What use is finance?

In most fields of employment, the value of what people do is obvious, e.g., construction
workers, health professionals, and farmers. In contrast, people, even those who you might
expect to be sympathetic to finance, are uncertain that finance is useful.
For instance, an editor of The Economist, a highly influential news magazine that is typically
very sympathetic to capitalist ideology, has written a report headed “What good is finance? It
is surprisingly difficult to say”. The report includes the following points:
“There are many financial innovations which seem to be serving some visible purpose worth
the occasional damage markets do to the real economy. And there are others which seem to
produce a great deal of wealth for financial intermediaries and little else.. … I would say
that ordinarily, economic actors ought to be left in peace to do as they wish until it can be
shown that their actions are causing some kind of harm. At this point, however, it seems

1
"What Good Is Wall Street? Much of what investment bankers do is socially worthless" by John Cassidy The
New Yorker 21 November 2010. https://www.newyorker.com/magazine/2010/11/29/what-good-is-wall-street
2
“Key facts about the UK as an international financial centre: 2018” by The CityUK (October 2018). Available
at https://www.thecityuk.com/assets/2018/Reports-PDF/94053cfc7b/Key-facts-about-the-UK-as-an-
international-financial-centre-2018.pdf
3
“Composition of the Australian Economy: Snapshot” (as at 10 Jan 2020) by the Reserve Bank of Australia
(RBA) available at https://www.rba.gov.au/education/resources/snapshots/economy-composition-snapshot/
4
“Financial Services: Overview” published by the Australian Industry and Skills Committee. Available at:
https://nationalindustryinsights.aisc.net.au/industries/financial-services Updated 31 October 2019.

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 fair to place the burden of proof on the financial sector that their practices are worth the
trouble to society (emphasis in bold added).”5
If The Economist harbours doubt about the value of finance, there is clearly a problem to
address. For students going to work in the finance sector, understanding how finance adds
value is particularly important since they will have to justify what they do to others and also to
themselves.6 There is another important reason. Finance work, like work in many other sectors,
is increasingly specialised. The skills and competencies required in the finance sector are often
not obvious; nor is the kind of particular work. To identify which skills are relevant and in-
demand requires an understanding of how finance adds value.
How finance is useful
Well-functioning financial markets facilitate four useful objectives:
A. Storage and exchange of value
B. Inter-temporal matching of consumption and productivity
C. Efficient risk sharing
D. Separation of ownership and management

A: Storage and exchange of value

If your business is successful, it will generate wealth. How does one store wealth? Two of the
three 2019 Nobel Prize winners in Economics, Abhijit Banerjee and Esther Duflo, describe one
solution common in developing countries where access to a modern financial banking system
is unavailable for many. Banerjee and Duflo point out that in the less affluent suburbs of
developing countries there are many unfinished houses, many of which have not been worked
on in months. They comment:
"If you ask the owners why they keep an unfinished house, they generally have a simple
answer: this how they save ... At first sight, unfinished houses don't seem to be the most
attractive savings instrument. One cannot live in a roofless house; a half-built house can
collapse in the rains; and if money is need for an emergency before the house is finished
and it has to be sold incomplete, the partial construction may be worth less than what it
originally cost to buy the bricks. For all these reasons, it would seem more practical to
save cash (say, in a bank) until enough money has accumulated and then build at least an

5
The Economist, “What good is finance?” column 27 August 2009 (Paywall: subscription required to access
more than a limited number of free articles per month).
Incidentally, I recommend The Economist for an informed perspective on important economic issues and many
other topics as well. Its strong points include the variety of coverage, the (mostly) intellectually consistent
coverage and the crisp, clear and engaging writing. The reader is never in doubt about The Economist’s point of
view. Unusually, the magazine doesn’t reveal the names of its writers. For an excellent critique of the magazine,
read Pankaj Mishra’s review of Liberalism at Large by Alexander Zevin (2019). You may be put off the magazine
after reading Mishra’s review, particularly his summary of the way The Economist approached several key issues
in its early days (it was founded in 1843), but that would be unfortunate. Try to work past that. Being able to take
in a confident, well informed perspective and develop your own critique of its strengths and weaknesses is a very
useful skill to develop. The Economist is a worthy tool for this purpose.
6
The notion of justifying to yourself the work you do may seem odd. However, economists increasingly recognise
what sociologists have long known: what you do and why you are motivated to do it is tied to your sense of
identity and it is important that you believe what you are doing is worthwhile. See "Identity and the Economics
of Organizations" by George A. Akerloff and Rachel E. Kranton Journal of Economic Perspectives v19(1):-32.
Akerloff, the husband of Janet Yellen, former Chair of the US Federal Reserve, is a Nobel Prize winner in
Economics.

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 entire room, complete with a roof, in one go. If the poor still save brick by brick, it must be
because they have no better way to save"7

What would be your ideal way to store wealth? Think of the requirements. You will probably
want to:
(a) store the wealth in a form that will retain its value over time;
(b) access your wealth easily and be able to move it conveniently;
(c) have it widely accepted in exchange for other goods;
(d) store the wealth inexpensively;
(e) have the wealth be secure from theft;
(f) keep it in a way that will not tempt you to consume it too soon.
While all the above qualities are desirable, it is practically difficult to find a solution that fulfils
all of them. Any particular solution will require a compromise on one or more of the desirable
qualities. Further, all solutions have to address a social challenge and a technological
challenge. The social challenge is getting people to agree on a common measure of value. The
technological challenge is finding a way to represent that value and devising ways for people
to exchange value, e.g., if people agree a bunch of bananas costs five dollars then handing over
a five dollar note in exchange for the bananas is how a transaction is accomplished. The concept
of a dollar being an agreed unit of value is the solution to the social value and the use of paper
notes and coins to represent dollars is the technological solution.
As the above example shows, money (i.e., currency) is used as a measure of value and also as
the medium of exchange. The extraordinary, wonderful, and somewhat mysterious aspect of
money is how readily people accept it as a measure and store of value. People, most unknown
to each other or even unseen, somehow agree that a particular token represents some unit of
value and they establish a way of exchanging these tokens to transfer value from one person to
the next.8
The use of money is a remarkable act of cooperation. The Israeli historian Yuval Hariri aptly
conveys how extraordinarily well people cooperate when it comes to money:
“For thousands of years, philosophers, thinkers, and prophets have besmirched money and
called it the root of all evil. Be that as it may, money is also the apogee of human tolerance.
Money is more open-minded than language, state laws, cultural codes, religious beliefs, and
social habits. Money is the only trust system created by humans that can bridge almost any
cultural gap, and that does not discriminate on the basis of religion, gender, race, age, or
sexual orientation. Thanks to money, even people who don’t know each other and don’t trust
each other can nevertheless cooperate effectively”9.

7
Ch. 8 "Saving Brick by Brick" in Poor Economics: A Radical Rethinking of the Way to Fight Global Poverty
by Abhijit Banerjee and Esther Duflo Public Affairs 2011 p. 183/184.
8
A famous example of how agreement on a common currency comes about is recounted in a classic economics
article, “The Economic Organisation of a P.O.W. Camp” by R.A Radford Economica 1945 v12(48):189-201.
P.O.W. is the acronym for “prisoner of war” and the economist Richard Radford who was interned in a German
prisoner of war camp during World War II recounts how cigarettes become the currency used by the prisoners to
trade among themselves and store their wealth. Radford’s account is famous because he shows how problems
that appear in the “real economy” also manifested in the camp’s economy. The references and style of writing is
somewhat dated so you may find it more helpful to read later summaries and discussions of the article that appear
on the Internet.
9
Ch. 10 “The Scent of Money” in Sapiens: A Brief History of Mankind by Yuval Hariri

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Although the functioning of money relies on implicit cooperation between people who don’t
necessarily know each other but agree on what money is worth, they also require a technology
to record and attest to the transfer and value of money. Problems arise when the technology
proves inadequate. For instance, around the year 1460, Europe ran out of silver bullion that
was used to mint money. An economic depression ensued as:
"the economy of Europe ground to a halt at every level, from the humblest purchase of
bundles of leeks, up to the great merchants, whose galleys had to row away with goods
unsold".10
A couple of centuries earlier, the Chinese solved the bullion shortage problem by printing paper
money that was backed by coins, i.e., one could, in principle, exchange the paper money for
coins.11 This meant the supply of money effectively extended beyond the amount of physical
coin circulating as people didn’t, in practice, actually exchange the paper money for coin as
long as they were confident it could be done. The Chinese Emperor Kublai Khan, grandson of
Genghis Khan, was the first to introduce paper money that wasn’t backed by coins. This is
known as “fiat money”: the money is accepted because the government says it is worth a certain
value. Fiat money was a considerable advance in economic history. As the financial writer and
historian James Surowiecki has noted:
“And when the Italian merchant Marco Polo visited China not long after, he marveled at
the spectacle of people exchanging their labor and goods for mere pieces of paper. It was
as if value were being created out of thin air”.12
The well-recognised risk with fiat money is that the government is tempted to create more and
more of it so that inflation ensues and the currency loses value. Indeed, a few decades after
Kublai Khan introduced paper fiat money, uncontrolled printing led to rampant inflation which
made the paper money worthless. Venezuela offers a present-day example; in January 2019 at
the peak of its (still on-going) hyper-inflation it took 14.8 days for prices to double.13
The freedom of governments to, in effect, print their money worries many people. Their fear
is that governments will be tempted to be reckless and print too much thereby igniting hyper-
inflation. Despite this commonly expressed concern, excessive production of fiat money is not
common. Indeed, today most major currencies, including the US dollar, the UK pound, the EU
Euro, the Chinese Renminbi, and the Australia dollar are fiat money and the problem that the
monetary authorities are combating is not inflation but deflation (an important issue that we
discuss in later weeks). Another concern of some people is that government control of currency
gives it too much power.
Currency issued and backed by the authority of sovereign governments and that is stored in
banks (e.g., Aus$450 kept in a Westpac bank account) is by far the most common way to store
and exchange wealth, probably because it is so convenient and has proved workable. Note two
features of this arrangement: the government has the most influence on the amount of money

10
P. 362., Ch. 15 "The Bullion-Famines of the Later Middle Ages" in Money and its Use in Medieval Europe by
Peter Spufford, Cambridge University Press, 1988.
11 "
The history of paper money in China" by John Pickering Journal of the American Oriental Society 1, no. 2
(1844): 136-142
12
"A Brief History of Money Or, how we learned to stop worrying and embrace the abstraction" by James
Surowiecki IEEE Spectrum 30 May 2012 https://spectrum.ieee.org/at-work/innovation/a-brief-history-of-money
13
“Venezuela’s Hyperinflation Drags On For A Near Record - 36 Months” by Steve Hanke. Forbes 13 November
2019 https://www.forbes.com/sites/stevehanke/2019/11/13/venezuelas-hyperinflation-drags-on-for-a-near-
record36-months/#22a0fd1c6b7b

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in circulation (via the central bank, e.g., the Reserve Bank of Australia) but the private sector
manages the holding and distribution of money.14
Whilst government control of currency is unlikely to remain unchallenged, it is also possible –
and has been the case in the past – that private entities can issue currencies. The development
of blockchain technology that allows the creation of so-called crypto-currencies that promise
better security, lower inflationary risk and more independence from government in areas such
as taxation has, over the past ten years, generated much speculation that traditional currencies
will be overtaken by currencies such as Libra which are allegedly easier to use for many people.
Evaluating the prospects of any particular privately-issued cryptocurrency overwhelming
government-issued currency is beyond the scope of this unit. If you are interested, the way to
make a start is by considering just how a cryptocurrency can achieve the requirements of an
ideal currency - listed at the start of this section – better than government-issued currency.
Note that a private currency may be viable if it is better for some purposes than the government
issued currency. For instance, illegal drug sales or attempts to avoid international currency
exchange controls may be easier with some privately issued cryptocurrencies.
In the opinion of the lecturer, private cryptocurrencies are unlikely to dominate government
currencies. What is more likely is that governments will increasingly switch to issuing their
own cryptocurrency using the blockchain technology. This will give them greater oversight
and control over citizens’ finances. Nine countries have done so already.15 Expect to hear
several significant announcements in 2022.
In closing, the point of this section is not so much to detail the intricate mechanisms of the
monetary system – although I hope you will be intrigued to learn more – but rather to show
that the provision of a method to conveniently and safely store wealth and be able to easily
transfer wealth in transactions is a very substantial benefit of a well-functioning financial
system. The work of Jyothi, the banker to slum dwellers, which is described in Stuart
Rutherford’s report “The poor and their money”, shows in a clear way the significant positive
difference that access to storage of wealth makes to people’s quality of life.

B: Inter-temporal matching of consumption and productivity

In life, the periods in which one earns money do not closely coincide with the times when one
needs the money. One benefit of finance is that it allows people to bridge the gap when they
earn money and when they spend money.
“Afterpay” is, perhaps, a familiar example. Clients can “shop now, pay later”. How it works:
at participating retailers, clients can choose to split payments on their purchases into four equal
instalments. The first instalment is paid at time of purchase and the remainder over the three
succeeding fortnights. The only fees to clients are for late payments.16
The problem that Afterpay solves, allowing people to more conveniently bring forward the
purchase of typically non-essential consumer items before having saved the money to pay for
them17 illustrates clearly how finance bridges the gap between consumption and productivity:
People are able to buy something now by drawing on money that they will earn in the future.

14
See "Money creation in the modern economy" by Michael McLeay, Amar Radia, and Ryland Thomas. Bank of
England Quarterly Bulletin (2014): Q1. And "Money in the modern economy: an introduction" by Michael
McLeay, Amar Radia, and Ryland Thomas. Bank of England Quarterly Bulletin (2014): Q1.
15
“These 9 countries are trying to create their own digital currencies to beat crypto” by Marco Quiroz-Gutterrez
Fortune magazine 14 January 2022
16
https://www.afterpay.com/en-AU/how-it-works
17
This facility has, of course, long been offered by credit card companies so an interesting question is why
Afterpay has proved so popular with customers.

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It’s worth noting that Afterpay, a highly successful Australia innovation that has stimulated
competitors and been adopted in the US, has attracted criticism, in part because some people
believe the terms by which it offers credit to clients entraps them so they end up worse off,
most commonly by having to make late fee interest payments that they didn’t expect to make
perhaps because they are short-sighted. We return to this point later because (a) it illustrates
an important though often unresolved issue in finance about the boundaries of personal
responsibility in relation to the use of money and (b) shows how political influence is important
to companies in shaping government regulations and policy in a favourable direction. In
Afterpay’s case, it’s been said that “the ability of Afterpay founders Anthony Eisen and Nick
Molnar to shape the regulatory framework under which it operates is an important part of its
“special sauce”.18 Afterpay benefits by not being classified as a credit provider and therefore
not having to comply with the provisions of the National Consumer Credit Protection Regime.
The benefits of finance facilitating inter-temporal matching of consumption and productivity
is perhaps more persuasively shown by considering three major categories of occasions when
we need to access money that we aren’t earning:
(i) Life-cycle needs
(ii) Emergencies
(iii) Exploit opportunities

(i) Life-cycle needs: over the course of your life you will need money to invest in your
education, to purchase large-cost items such as housing and vehicles, and to fund your
retirement. In Australia, most people are able to access loans to finance their education and
housing and they also have access to investment opportunities to be able to earn a return on
their savings so they can live on the proceeds during their retirement.
In Australia, arrangements such as compulsory superannuation19, government-supported
student loan arrangements20 and a well-developed market for home mortgages have made it
easier than ever before to match consumption needs21 and earnings from productive work.
These arrangements and the relatively convenient way they can be accessed are a significant
benefit of a well-developed financial system.
Emergencies:
Illnesses and personal injuries and natural disasters such as bushfires have some probability of
affecting people but their timing, severity of impact and cost of recovery is typically unknown.
The ability to insure against these events is a great benefit, alleviating much anxiety both before
they occur and afterwards when the unfortunate event occurs.
It is worth noting that coverage of the cost of disaster is ultimately borne by those insured. The
benefit of insurance is that it is an efficient form of saving. Those insured don’t have to worry

18
“Afterpay’s hidden superpower” Chanticleer column by Tony Boyd Australian Financial Review 3 February
2021
19
Superannuation is the set of arrangements put in place by the Government of Australia to encourage people in
Australia to accumulate funds to provide them with an income stream when they retire. Participation in
superannuation is partly compulsory, and is encouraged by tax benefits. The government has set minimum
standards for contributions by employees as well as for the management of superannuation funds. It is compulsory
for employers to make superannuation contributions for their employees on top of the employees' wages and
salaries. Since July 2002, this rate has increased from 9 per cent to 10 per cent in July 2021, and will stop
increasing at 12 per cent in July 2025. Source (with minor changes in wording):
https://en.wikipedia.org/wiki/Superannuation_in_Australia (last accessed 1 March 2022).
20
https://www.education.gov.au/government-loans-students
21
Paying for education is probably better classified as an investment rather than consumption good but the point
remains: the finance system facilitates payment before one has earned the money.

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about having saved enough before the disaster strikes; the insurance company with its pool of
funds from those insured, is able to meet the costs of recovery even if the client just started
their policy the day before the disaster. Developing the right model to identify and risks
accurately and therefore price insurance correctly is a big part of finance work.
Exploit opportunities
Most significant business require more capital for investment than the founders are able to
save. For instance, Afterpay was launched in mid-2015 and a couple of months later it had
fewer than 10 retailers signed up and 2000 customers. To get larger the business needed more
capital and so in August 2015 the company approached NAB for funds. After extensive due
diligence, NAB lent Afterpay $20 million which allowed the company to scale up its
operations. NAB’s decision to lend proved sound, by April 2018, Afterpay had attracted 1.5
million consumers, signed up 12,000 retailers and annualised sales were $2 billion, and
growing.22 The point is, without access to capital, Afterpay would not have succeeded.
A well-developed financial market also allows countries as a whole to exploit opportunities.
These opportunities are not always what you might expect. For instance, in his study “Finance
before the industrial revolution: an introduction” the economic historian Meir Kohn writes:
"The commercialisation of war led to longer and more extensive conflicts to be better and
more expensive military technology. To mobilise the enormous sums they needed to wage
war, princes had little choice but to borrow and to hope that victory would provide them
with the means to repay"
The importance of finance in enabling war has long been recognised. In the first century AD,
Publius Cornelius Tacitus, a Roman Senator and historian, commented, “money is the sinews
of war”.
A contemporary, topical example of the relevance of finance in waging war is Forbes’
magazine report of the Russian central bank growing its gold reserves to $640 billion which is
said to be equivalent to 17 months of Russian export revenues.23 Of course, the reserves are
not much use if they can’t be spent. This is one reason economic sanctions have been applied
to Russia by many countries.
More generally, whilst finance enables more resources to be devoted to waging war, it is also
the case that well developed capital markets reduce the incentive to do so. On the whole, the
second factor is stronger. Contrary to what many, if not most, people think, we are living in the
most peaceful decades in human history at least on a global scale. Russia’s invasion of Ukraine
is shocking in large part because people had the view – which is accurate, in my opinion – that
it wasn’t in its interest to damage its economy by going to war. There is a prescient analysis
of the current situation by Harvard psychologist Steven Pinker in an article written in 2015.24
On a brighter note, the venture capital market, which is the pool of experts who specialise in
evaluating and funding entrepreneurs who develop new technology, is what provides incentives
for people to innovate and makes it possible for that innovation to be commercialised and made
available to the public. For instance, in December 2019, the Australian Financial Review
reported that Harrison.ai, a firm specialising in the use of artificial intelligence in healthcare
(example, developing an AI algorithm to select the best embryo for implantation in IVF
treatment) raised $29 million from Blackbird Ventures and three other companies. Harrison.ai

22
"How Afterpays Nick Molnar taps into Millennials spending habits and wallets" By James Eyers Australian
Financial Review 12 April 2018
23
“How Can Putin Afford War In Ukraine? His $130 Billion Gold Horde Helps” by Christopher Helman Forbes
31 January 2022
24
“Steven Pinker explains how capitalism is killing war” by Zack Beauchamp VOX Jun 4, 2015

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was founded by brothers Aengus and Dimitry Tran, who immigrated to Australia from Vietnam
for high school.25
The examples I have provided show that finance is useful for people who are already
reasonably well off. This can make finance seem like a luxury good; nice to have but not
essential. In practice, finance can make the biggest difference to the lives of the desperately
poor.
In his (1999) book, “The Poor and their Money: An Essay about Financial Services for Poor
People”, Stuart Rutherford notes that poor people also have occasions when they need to spend
substantial sums of money. He notes poor people also have life-cycle needs and:
“many of these needs can be anticipated, even if their exact date is unknown. The awareness
that such outlays are looming on the horizon is a source of great anxiety for many poor
people. [Further], emergencies … create a sudden and unanticipated need for a large sum
of money … Personal emergencies include sickness or injury, the death of a bread-winner
or the loss of employment, and theft or harassment. Impersonal ones include events such as
war, floods, fires and cyclones, and - for slum dwellers - the bulldozing of their homes by
the authorities…Finding a way to insure themselves against such troubles would help
millions of poor people”
Economists Thorsten Beck, Asli Demirguc-Kunt, and Ross Levine completed a study
“Finance, Inequality, and Poverty: Cross Country Evidence” and found that:
“increased financial development in a poor country induces the incomes of the poorest
people in that nation to grow faster than the average per capita gross domestic product
(GDP) -- that is, the nation's output of goods and services divided by its population. In turn,
income inequality falls more rapidly, and poverty rates decrease at a faster rate, than would
otherwise be the case. For example, consider Brazil: the average income of the poor in
Brazil would have grown at more than 1.5 percent per year instead of not at all from 1960-
99 if Brazil had the same level of financial intermediary development as Korea”. 26

C: Efficient risk sharing

An important benefit of well-functioning financial markets is the efficient allocation of risk.
What this means is that finance allows the risk of a project to be spread to those people most
able to bear the risk, relieving the risk of people least able to bear it or who are unwilling to
bear it. By efficiently allocating risk, projects get started that otherwise would not have been
feasible and so productivity increases.
For example, a farmer may wish to plant a crop for export but is concerned that if there is a
glut on the market (i.e., a very large harvest brings on too much supply) then prices will fall
and she may not be able to cover the cost of growing the crop. In this case, the farmer may
prefer not to take the risk and avoid planting the crop. Finance offers a solution via the sale of
futures contract, as this historical example shows:
“In the 19th century Chicago's trading pits offered an organized venue in which farmers
and other suppliers of agricultural commodities, such as warehouse owners and brokers,
could remove the risk of price fluctuations from their business plans.

25
"Big names pile in to back Aussie AI health pioneer with $29m" by Yolanda Redrup Australian Financial
Review 9 December 2019
26
“Financial development helps the poor in poor countries” Summary of research available at
https://www.nber.org/digest/jul05/w10979.html

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 Farmers who planted corn in the spring had no way of knowing what the price of their crop
would be when they harvested in the fall. But a farmer who planted in the spring and sold a
futures contract committed to deliver his grain in the fall for a definite price.
Farming was risky enough, thanks to uneven rainfalls and unpredictable pests, without
adding the risk of changes in market prices.”27
Financing large scale infrastructure such as Elizabeth Quay, toll roads and hospitals requires
more complicated contracts to be designed and negotiated. There are two kinds of risk that
need to be mitigated. One is that of ensuring that everyone has the right incentives to complete
their side of the contract efficiently and the other is the risk of financial loss if the project
doesn’t turn out to be as successful as expected. In these cases,
“project finance, and the complex web of contractual arrangements that such funding
entails, are used to address “agency problems” that reduce efficiency in large
organizations, private as well as public. … The contracts among the multiple parties to
project financings are risk management devices designed to shift a variety of project risks
to those parties best able to appraise and control them”28.
The value of project finance specialists, that is, people who are skilled at designing effective
and efficient contracts so that multiple parties can work with each other is evident in the size
of their pay. For instance, Brendan Quinn, a lawyer specialising in project finance, was offered
a $2.6 million pay package to move to law firm White & Case in 201729. Better contracts make
a large difference in outcomes. In 2019 it was reported that a
“2016 Grattan Institute analysis of all 836 infrastructure projects valued at $20 million or
more found that cost blow-outs accounted for nearly a quarter of the total budgets of mooted
or built projects since 2001”.30
Efficient risk sharing in finance isn’t just a matter of individual contracts being well designed.
Particular locations can specialise in the efficient allocation of risk. For instance, “Silicon
Valley”, is the name given to a region near San Francisco that specialises in providing venture
capital to technology entrepreneurs31. It has attracted a critical mass of specialist people so that
finding support for a start-up new technology company is easier to do there then most other
places in the world.
Similarly, Western Australia is one of the easiest places in the world to set-up a mining
exploration company which means that entrepreneurs who wish to explore in regions far from
WA such as West Africa or Mongolia will often have their headquarters in Perth. For example,
Mr Asimwe Kabunga is a Tanzanian-born Australian entrepreneur who is the Chairman of two
ASX-listed companies based in Perth, Lindian Resources and Volt Resources. Lindian
Resources’s bauxite mines are located on the East and West coasts of Africa and Volt
Resources has graphite mines in Guinea and the Ukraine.

27
“Futures and Options Markets” By Gregory J. Millman, The Library of Economics and Liberty
http://www.econlib.org/library/Enc/FuturesandOptionsMarkets.html
28
“Using Project Finance to Fund Infrastructure Investments” by Brealey, Cooper, & Habib Journal of Applied
Corporate Finance (1996) v9.3
29
"'When do we pull the pin': Inside Herbert Smith Freehills' partnership breakup" by Misa Han Australian
Financial Review 20 Feb 2017
30
"The dysfunctional contracts at the heart of our infrastructure boom" by Scott Langdon Australian Financial
Review 8 July 2019
31
For an unusually set out but intriguing history of Silicon Valley, read “Silicon Valley History” by Gregory
Gromov, available at http://silicon-valley-history.com/Silicon_Valley_History.pdf

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The convenience of doing business in WA for mining companies has led the Mike Henry, CEO
of BHP Ltd, one of the world’s largest mining companies, to declare that “WA is the Silicon
Valley of the global resources industry”.32
One of the ironic aspects of modern finance is that many claim the increased development of
finance has made the world more rather than less prone to financial catastrophe. This is ironic
because a well-developed financial system should have the opposite impact as it allocates risk
to those who are better able to bear it. In 2005, Raghuram Rajan, then Chief Economist of the
International Monetary Fund, wrote a famous paper “Has financial development made the
world riskier?” in which he pointed out that some financial innovations had led to certain
intermediaries taking on more risk than they were able to support. This meant that the
intermediaries could not be relied upon to absorb losses when they arose and consequently the
losses were spread more widely with catastrophic consequences. This kind of risk is an ever-
present one and we shall discuss in later in the semester.

D: Separation of ownership & management

It is quite likely that, over your lifetime, you will earn more money from investing than your
personal labour. That is, your wages will be outstripped by the income from your investments.
In most cases, the attention you give to managing your investments will be a small fraction of
the attention you give to your regular job. Essentially, you will send your money away to be
managed and invested by someone else and they will send the proceeds from the investment
(if any) back to you after deducting their fees.
Think about how remarkable the above situation is. You are sending your money to be
managed by strangers, people you are highly unlikely to meet in person, and you have a
reasonable and mostly justified expectation that your money will be returned to you with
interest. It is amazing that so many people are able to sleep well at night, secure in the
knowledge that their wealth is being kept and managed by strangers. Fostering this level of
trust and cooperation is what corporate governance is all about.
The issues with giving wealth to other people for them to manage is an old one. There is a
famous parable in the Bible, the Gospel of Matthew chapter 25, verses 14 to 30, which tells of
a rich man who gave “talents” (i.e., sums of money) to three of his servants to manage whilst
he went away. Two of them invested well and doubled the money they were given. They were
handsomely rewarded by their master when he returned. The third was too scared to take a
risk and hid the talents he was given in the ground to keep safe. When the master heard this,
he was very angry and banished the servant from his house.
I’ve feel some sympathy for the fearful servant when I hear the parable but I guess the point is
that to make a profit you need to take a risk. Investing has always entailed risk however the
present economic environment is more than usually interesting in respect of evaluating risk.
For close to thirty years interest rates have come down and, as a result, asset prices have
increased so those who have been invested over this whole period have made very large capital
gains (we will review some figures in week 2).
The problem now is that interest rates are so low that people cannot rely on interest income
from their investments being sufficient to generate enough money for their needs. The
following excerpt from a 2020 news article illustrates the problem.

32
“New BHP boss flags tech focus” by Nick Toscano The Age 28 November 2019 The Age

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 "Low interest rates open generational divide: poll"
by Phillip Coorey Australian Financial Review 4 Feb 2020
“Voters are polarised over Australia's chronically low interest rates – mortgage
holders are in no hurry to see them rise while retirees say they are being forced to take
more risks with their money to get by.
The focus research showed a universal concern among retired voters about the record
low rates and the prospect of them remaining that way for some time.
"You can only make money if you want to take a risk,'' said one man, aged 68.
He, and others in his age group, believe more retirees will be forced to rely on the
pension in the current environment.”
Those who either have mortgages or are young and wanting to buy a house are happy
with the low rates.

The reasons interest rates are so low and the implications for investment (and inter-generational
equity) are issues we shall address over the next few weeks. The issues are ones in which you
implicitly have to make a decision but without knowing if it will pay-off (that’s the risk part).
The main point I wish to emphasise here is that an important use of finance is that it allows the
separation of ownership and investment. You can work on what you do best and give your
wealth to specialists to manage. Of course, identifying the right specialist is a challenge. This
is another issue we shall address.

What kind of work does finance involve?

The competencies and work required in some occupations are easy to identify. Most people
know, or at least think they know, the kind of work that, say, a carpenter or butcher or computer
programmer does. This is not the case with finance. Oddly enough, even people in the third
year of studying finance find it difficult to identify the kind of work required in finance. Sure,
we know that a banker lends money and it is helpful to be able to borrow money when needed
but, to illustrate the problem, can you readily identify what exactly investment bankers do that
keeps them so busy?33
Many, indeed most, people do not understand what an investment banker does. Here is an
overview: An investment banker is a middleman who facilitates a transaction between buyer
and seller, in the same way that a real estate agent does. To put it another way, an investment
banker is an intermediary. She or he – as it happens, they are mostly male, a point we will
address later – provides services that enables two parties to do business together.
The notion that it is helpful to have someone connect sellers and buyers is straightforward to
understand. What many people find outrageous and difficult to understand is why middlemen
often are able to capture so much of the profit from a transaction. For instance, British
journalist Sir Max Hastings has written: “Many of us do not grudge cash to real wealth-
generators … who have created their own businesses and a lot of jobs from scratch. It is
managers, middlemen simply creaming a percentage of everything that passes through their
hands, who provoke resentment”. 34

33
Here is a recent comment from a commerce graduate who decided to leave investment banking: "The industry
is marked by incredibly long hours. The ability to maintain any semblance of a social life, while working at an
investment bank, seemed impossible … I didn't want to work like a slave for a decade at an investment bank and
wake up at 35 to realise that I had no friends or social life" ("Investment banking no longer the 'holy grail'" by
Tim Boyd and Lucas Baird Australian Financial Review Jul 13, 2019).
34
“They've never had it so good: Today's filthy rich are wealthier, healthier and more secure than ever” by Max
Hastings The Guardian Sat 6 Aug 2005

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No one is forced to use a middleman. If they make money it must be because the buyers and
sellers who use them find they provide a service worth paying. To understand the value
generated by middlemen it is helpful to analyse in some detail what goes on when people
engage in a transaction and how middlemen assist in facilitating such transactions.

Incidentally, you will not find substantial discussion of intermediaries and the different
elements of transactions in many finance textbooks.
In fact, I am not aware of any other finance textbook that covers this material, which is
odd because knowing the kind of work that middlemen do is critical to understanding the
finance industry and the work of financial professionals.

Elements of transactions
The various processes that take place when a seller and a buyer have a transaction (e.g., when
someone sells their car) can be usefully classified into six categories.
1) Process of buyer and seller finding each other and able to exchange goods (or services)
– being a bridge
2) Process of confirming quality of good (or service) or of counter-party – being a certifier
3) Process of monitoring and enforcing terms of agreement – being an enforcer
4) Process of risk allocation in event of failure – being a risk-bearer
5) Process of getting information – being a concierge
6) Process of negotiation – being an insulator
The extent to which each of the six processes is important in each transaction varies
considerably. If you’re buying a second-hand car from your aunt who you trust completely,
who gives you a great price because you are her favourite niece/nephew, and you know the
condition of the car because you have been driven in it since you were a child then the
transaction occurs very quickly (before she changes her mind) and you are hardly aware of
going through any of the processes.
In other cases, when the buyer and seller aren’t acquainted with each other; when they may not
even know the other person exists, then it is helpful to have an intermediary (a middleman)
assist with the six processes. In some kinds of transactions, each of the processes is significant
enough to have a middleman specialising in that process alone. Here are examples from the
financial sector of each process operating with a specialist

Bridge: Providing opportunities for buyers and sellers to get connected

Assume you identify a section of the economy that you believe will earn higher returns.
Potential examples: aged care providers, management of “big data”, online shopping, and
“clean” power. If you wish to invest in these parts of the economy you need to find a vehicle
to invest in. It can be difficult to do so if you have only a few thousand dollars to invest because
your costs in researching each sector and then finding suitable companies to invest in may chew
up all your investment. This is where a specialist firm like Atlas Trend
(https://www.atlastrend.com) can help you. Kent Kwan, a UWA BCom and LLB graduate, co-
founded Atlas Trend to allow people to learn about and invest in world trends such as the three
they have labelled “Big Data” “Clean Disruption” and “Online Shopping Spree”.
Atlas Trend is an intermediary that primarily serves as a “bridge”. It connects customers to
investment opportunities that they would otherwise not be able to access.

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Certifier – Confirming quality of product or service or counterparty
Unsurprisingly, in banking it is useful to know whether a borrower has the capacity (and
intention) to repay a loan. Increasingly, regulations require financial institutions to know that
their customers are not using the institutions’ facilities to conduct illegal business. If financial
institutions are found to have enabled illegal behaviour they face significant penalties. For
instance, in November 2019, Peter Dutton, the Home Affairs Minister in the Australian Federal
Government, accused Westpac Bank of having “given a free pass to paedophiles” by not
having a system in place that identified “suspicious” patterns of payments. The allegedly
inadequate Westpac systems also facilitated money-laundering by criminals.35
Commonwealth Bank was also found guilty of enabling money-laundering and had to pay $700
million fine.36
Westpac’s problems show there is demand for a service that can certify that a customer is not
a criminal and has good credit. One RegTech company supplying such a service is iSignthis.37
iSignthis certifies to banks that their clients are conducting legitimate business, at least in
relation to their financial transactions. It assists financial institutions to comply with “know
your client” (KYC) regulations and also anti-money laundering (AML) regulations.
The service offered by iSignthis has been in such demand with the advent of more strict KYC
and AML regulations that over the nine-month period from January 2019 through to September
2019, the shares of iSignthis, which is listed on the ASX, had a return of 946% and its total
value of equity went over Aus$1.1 billion. (Ironically, iSignthis has been suspended from
trading around 2 October 2019 and the suspension continues as of the time of this writing –
early March 2022).38
iSignthis is an intermediary that offers certification. It helps assure parties to a transaction that
they are dealing with reputable, legitimate entities.

Enforcer – Monitoring and enforcing the terms of a contract

Most people borrow money with every intention to repay it according to the terms of the loan.
Some of these people fail to honour the terms of the contract. In this case, the lender needs to
have some means of encouraging or even forcing (legally) the borrower to repay. Without
some sort of enforcement mechanism the market for loans would not exist, as lenders would
refuse to lend. If the enforcement mechanism is very effective and low cost to implement then
it’s not necessary to check on creditworthiness because potential borrowers will know they
cannot avoid payment. This is why criminal gangs get into the money-lending business and
offer loans to desperate people at high rates; they are confident that beating up a few recalcitrant
borrowers sends an effective signal to other borrowers they need to repay their loan.
Criminals use illegal brute force. Law abiding money lenders must use less intimidatory
tactics. Sometimes the fear of embarrassment is enough. In his book, Financing the American
Dream: A Cultural History of Consumer Credit financial historian Lendol Calder describes
“bawlerouts”; women who were hired by small lenders in late 19th century America to visit

35
“Money-laundering” is the activity of using illegally acquired money to undertake transactions that result in it
being difficult or impossible to identify the illegality of the source of the money. The money is thereby laundered
(i.e., cleaned).
36
"Westpac has "given a free pass to paedophiles"" by Philip Coorey Australian Financial Review 25 November
2019.
37
RegTech stands for regulatory technology. The term refers to companies that offer other companies
technological services to help them achieve regulatory compliance.
38
"iSignthis faces ASX, ASIC inquiries after shock suspension" by Jonathan Shapiro and Vesna Poljak Australian
Financial Review 2 Oct 2019. See also “Signthis ditches licence bid as Karantzis moves to Cyprus” by Michael
Roddan Australian Financial Review Jan 4, 2022

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borrowers who wouldn’t repay their loans and “bawl” them out in front of family, work
colleagues or friends. The fear of social embarrassment was usually enough to make them
repay.
The relationship between lender and borrower doesn’t have to be bad. Calder tells about a
woman who remembered a peddler who sold her family a sewing machine and came back
every week for 18 years to collect the weekly payment of 25 cents. By the time the loan was
paid off, he had become a trusted family friend. (I remember on one of my visits to my
grandmother in India, she introduced me to the village moneylender, who had helped her out
on occasion with a loan when she was a young widower raising two small boys. I don’t think
they were exactly friends but there was a mutual respect and the money lending service he
provided was an essential lifeline).
Bawlerouts are intermediaries that enforce contracts. Without intermediaries who enforce the
terms of contracts, there would be much fewer loans, if any, provided.

Risk-bearer – Assumes risk of failure if a transaction is not successful

A company may want to issue shares to the public but is concerned that it may not raise enough
money to finance its project. If it doesn’t raise enough money, the project will fail. In this
instance, an intermediary may offer to “underwrite” the capital raising in return for a fee. The
underwriter, who is the intermediary, is essentially guaranteeing a minimum amount of money
will be raised so the company can issue shares confident it will raise at least enough money to
proceed with its project.
In February 2021, WA-based ASX-listed mining company Hasting Technology Metal went to
investors seeking to raise around $57.2 million. The deal was priced at 19 cents per share,
which “represented a 20.8 per cent discount to the company’s last close and a 9.9 per cent
discount to its five-day VWAP [volume weighted average price]”.39 Canaccord Genuity
Patersons, a Perth-based financial services firm, was hired as the “lead manager” and
underwriter. Essentially, Canaccord Genuity undertook to oversee the selling of the new stock
and to guarantee to buy any unsold stock to make up the difference if the fund-raising fell short
of the target of around $57.2 million.
Canaccord Genuity is an example of a risk-bearer that facilitates transactions by accepting the
costs of the risk of failure if the desired outcomes don’t eventuate. In this case, because it is
the lead manager in charge of selling the stock it is able to control the outcome to some degree,
which is why it feels confident it can on the risk.

Concierge – provider of information that facilitates transactions

Michael Bloomberg, whose wealth totals around US$70 billion, is the richest candidate to have
run for the presidency of the United States. He earned his wealth, after being laid off by his
company, by building a “computerized system to provide real-time market data and other
financial calculations to investment banks and Wall Street firms, which [was] sold as a
subscription service”.40 In 2020, a commercial subscription for a Bloomberg Terminal cost
around US$20,000 to $24,000 and Bloomberg has over $325,000 subscribers. The Business
School has subscriptions for several Bloomberg Terminals, many located in the Trading Room.
Students interested in working financial services should use them to become familiar with how
they work as they are used in many firms.

39
“Small cap mining duo launch raisings” by Sarah Thompson, Anthony Macdonald and Tim Boyd Australian
Financial Review Feb 18, 2021
40
“How Michael Bloomberg made his $65 billion net worth” by Emily Jacobs News.Com.Au February 20, 2020

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The Bloomberg company is an intermediary that provides timely, relevant information to
people in the financial services industries in a form they can easily access. Bloomberg’s
business is an example of a concierge service.

Insulator – someone who negotiates on behalf of the parties to a transaction.

Former US President Donald Trump’s book Trump: The Art of the Deal (1987, ghost-written
by Tony Schwartz) was one of several things that first brought him to the public’s attention.
Although one might quibble with Trump’s tips or even doubt whether he follows them himself,
it is true that effective negotiation can make a big difference to the outcome of a deal.41
Pertinently, successful negotiators typically focus on getting the best outcome for both sides,
and not on making the other side feel like a loser (to reference a favourite Trumpian pejorative):
“Focus on the win-win.
Win-wins are the only way to go. If you approach a negotiation thinking only of yourself,
you are a terrible negotiator. Understanding what all parties need and working for all
concerned is vital. Keep in mind that seeing things in only black and white (win-lose) creates
limited thinking; creativity is essential to good negotiation. Ultimately, all people involved
should find themselves on the same side of the fence. You want to be a player, not a pain.
Keep your eye on the big picture and don’t get caught up in the small stuff. Stay out of the
weeds”.42
It takes skill to be a good negotiator and successful business people understand this which is
why they recognise the value in hiring a specialist to negotiate on their behalf. For instance, in
February 2020 Melbourne-based financial planner Adam Patching engaged a buyer’s agent,
Cate Bakos, to bid on his behalf at a home auction. Mr Patching presumably recognised that
paying for Ms Bakos’ services would result in a better outcome for him than if he bid on his
own behalf.
Cate Bakos is an intermediary who conducts the deal of buying a house on behalf of the buyer.
Intermediaries like Ms Bakos use their skills and experience to get a better outcome for the
buyer (or seller) than their clients would get if they negotiated themselves.

Further relevant points about intermediaries (i.e., middlemen).

The six transaction processes are not always, or even often, neatly separated
In explaining the six processes of transactions I have provided examples of intermediaries who
specialise to a high degree in one of the processes. I did this to make more clear what each
process involved. In many cases, an intermediary will deliver not just one process but two or
more.
No substitute for experience
The description I have provided of the six processes in a transaction is a highly abstracted
theoretical model. The six processes can be accomplished in many different ways depending
on the technology, regulatory environment, and type of transaction. There is no adequate
substitute for experience or local situational knowledge. What this means is that to be an

41
I once had an MBA student, a former school teacher, who made money on the side by offering the following
deal to his fellow students: They would go to a car dealer and get the best price they could negotiate for a particular
car but then not buy it. He would then go and see the same dealer after them and negotiate a better price. He
would then split the difference with the actual buyer. I often wonder what career he had after graduation.
42
Excerpt from: "5 Steps to Master the Art of Negotiation" by Michael Mamas Entrepreneur Asia Pacific edition
https://www.entrepreneur.com/article/253074

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accomplished, competent intermediary you have to know the specific details of the particular
field you are working in.
Notwithstanding there is no substitute for experience, you can get a deeper appreciation of the
value created by and the kind of specific skills and knowledge required to be an intermediary
by reading Marina Krakovsky’s (2015) book The Middleman Economy: How Brokers, Agents,
Dealers, and Everyday Matchmakers Create Value and Profit. Ms Krakowsky draws on
academic research into intermediaries to provide an explanation enlivened by real, striking
examples that is easy for the layperson to read and understand. The first chapter, free available
on the web and also available in the Recommended Readings for Week 1 in LMS, provides a
very useful overview at more depth than I have provided. You will see that I have used Ms
Krakowsky’s labels for the six processes. The book is not specifically about the finance
industry. It is about middlemen in general but the points made are certainly relevant to finance.

Why is finance profitable? And, will it remain so?

Most people working in finance did not enter the sector because they love the work (or rather
they may love the work after being in the industry for some time but most would have been
indifferent about it when they started). The principal reason most people enter finance is
because they have heard the pay is good. This is a perfectly valid reason. It is how market
economies operates: when prices for resources are high in one sector, more resources are
directed to that sector resulting in a more efficient allocation of resources.
If you have heard that the pay is good in finance, the good news is that anecdotal evidence and
systematic research confirms this fact. Across virtually all developed economies, including
Australia, the evidence is consistent with the following finding:
"Compensation in the finance industry is higher and more skewed than in other sectors, and
has been increasingly so since the beginning of the 1980s ... Controlling for education and
other individual characteristics, ...the finance wage premium reached, on average, 50% in
2006, and 250% for the top decile of the industry".43
On a personal level, particularly if you have invested or intend to invest up to three or more
years studying finance, it is comforting to know you will be well compensated. On the other
hand, taking a society wide view, many people are disturbed by the extraordinarily high pay in
finance. They are concerned that there may be some kind of market inefficiency operating.
They wonder whether the high pay in finance is not supporting socially beneficial or productive
economic growth but rather is drawing talented people from other fields into finance.44
The notion that the finance sector is not truly productive is implicit in the UK Society of
Manufacturing Engineers’ advertising campaign aimed at students in 2009. The SME claimed:
“Engineers create real wealth by solving problems rather than creating ‘paper’ wealth by
playing with the markets.”
The well-regarded financial journalist Gillian Tett reported the above campaign slogan in her
Financial Times column on 6 April 2009, that is, shortly after the start of the global financial

43
"Returns to talent and the finance wage premium” (2019) by Célérier, Claire, and Boris Vallée The Review of
Financial Studies v32(10): 4005-4040.
44
Harvard University has extraordinary prestige in American culture (and indeed in much of the rest of the world)
and so just about every year for the past 20 years someone writes an article tut-tutting over the fact that a high
proportion (around 36%) of Harvard undergraduates intend to enter finance or consulting when they graduate (as
opposed to, say, science, medicine, engineering or helping the poor). See for instance, “The Draw of Consulting
and Finance” by Chris Hopson Harvard Political Review 15 July 2018 https://harvardpolitics.com/harvard/the-
draw-of-consulting-and-finance/

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crisis when banks were sacking large numbers of workers. Ms Tett saw a ray of hope in the
release of the finance workers. She said:
“After all, if finance no longer keeps monopolising the brightest and best workers, some of
that talent could be diverted into other, more productive, arenas – for the good of the
economy. Some of those financiers now being “demobbed” – or sacked – have strong
science or engineering backgrounds, and are sitting on spare capital. In an ideal world,
they would be perfect candidates to support manufacturing, information technology or other
high-tech start-ups of the kind that Europe in particular so desperately needs.”
The irony is that high-tech start-up don’t start spontaneously in the presence of engineers. They
need to attract capital and capital only arrives in the right kind of corporate structure and
contractual arrangements that the finance sector provides. Without venture capitalists like Ms
Tanisha Banaszczyk the chances of having a flourishing high-tech sector are low.

Three factors that affect profitability

Returning to the main question: will finance continue to be profitable? This question is of
course relevant to any investment. In general, there are three broad factors to consider when
analysing the likelihood of a sector or company being profitable on an ongoing basis. These
three factors are things that both analysts and CEOs need to focus on. The factors are:
(a) Economics,
(b) Technology, and
(c) Regulation.
Economics
Economics in this context refers to ensuring that the sector or individual business has a product
or service that is in demand, that is competitive with similar products offered by rivals, and
that can be sold for a price that covers the cost of production.
What does the economics of the finance sector lead us to expect in terms of ongoing profits to
this sector and the level of pay that finance workers can expect?45
Across modern, industrialised economies one broad fact is that the finance sector has grown
over the past 150 years at an increased rate since around 1980. Indeed, the terms
“financialization” has been coined to describe the increasing importance of finance, financial
markets and financial institutions in the economy.46 In the US, the financial services sector
contributed 2.8% to GDP in 1950, 4.9% in 1980, 8.3% in 2006 and 7.4% in 2018.47 In
Australia, financial services accounted for 9% of GDP in 2019.48
I haven’t been able to obtain the figure for China, which is unfortunate, given that it is the
world’s second largest economy by total GDP and largest by purchasing power parity (PPP).

45
The discussion here onwards draws largely from “"The growth of finance" (2013) by Robin Greenwood and
David Scharfstein Journal of Economic Perspectives v27(2):3-28. I also highly recommend "Does finance benefit
society?" by Luigi Zingales (2015) Journal of Finance v70(4): 1327-1363. Professor Zingales is an eminent
economist and former president of the American Finance Association (a largely ceremonial role that really signals
the respect of the academic finance community for the person elected president). This article was his speech to
the Association in the year he was elected.
46
"Financialization of the Economy" (2015) by Gerald Davis, Gerald F., and Suntae Kim.Annual Review of
Sociology v41: 203-221.
47
The figures till 2006 are from: "The growth of finance" (2013) by Robin Greenwood and David Scharfstein
Journal of Economic Perspectives v27(2):3-28. The figure for 2018 is from the US Department of Commerce,
see: https://www.selectusa.gov/financial-services-industry-united-states
48
RBA data. See https://www.rba.gov.au/education/resources/snapshots/economy-composition-snapshot/

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What is interesting is that China’s impressive economic development shows that rapid
economic growth is possible without a sophisticated financial sector.49 To be clear: China’s
financial services sector is becoming very sophisticated and indeed its payment technology is
easily the world’s most sophisticated but these developments came after rather than before
rapid economic growth. (More on China’s financial sector further on.)
So, why has the financial services sector grown so much in the US (and Australia)? Financial
economists Robin Greenwood and David Scharfstein attribute the growth in the US to two
activities:
“asset management and the provision of household credit. The value of financial assets
under professional management grew dramatically, with the total fees charged to manage
these assets growing at approximately the same pace. A large part of this growth came from
the increase in the value of financial assets, which was itself driven largely by an increase
in stock market valuations (such as the price/earnings multiples). There was also enormous
growth in household credit, from 48 percent of GDP in 1980 to 99 percent in 2007. Most of
this growth was in residential mortgages … The increase in household credit contributed
to the growth of the finance through fees on loan origination, underwriting of asset-backed
securities, trading and management of fixed income products, and derivatives trading.”
(p.5/6).50
The growth of asset management and growth in provision of household credit has fulfilled two
of the functions of finance: the ability to invest easily with professional fund managers has
meant that more people at different levels of income can easily participate in capital markets
without being expert investors. This in turn has increased the supply of capital available to
entrepreneurs which has lowered the cost of capital and thereby made it easier for new ventures
to start. The increase in provision in household credit means that more people are able to
smooth out their income over their life-time to match their consumption and expenditure. For
instance, now that it is relatively easy to get a mortgage, there is no need to wait until you are
in your, say, forties to save up enough buy your dream-house .
The growth in asset management and in household credit has increased the size of the financial
sector in both absolute and relative but it has also increased the number of people working in
the sector. Normally, when more people enter an industry or sector the pay comes down (you
will recall from Economics 101: when supply goes up, price comes down, other things being
equal). What is peculiar and unexplained by conventional economics theory is that although
more people have entered the finance sector because of the high profits and pay, this increase
doesn’t seem to have affected either profitability or pay to the extent we would expect.
To explain using a numerical example: let’s say market interest rates are such that you can
save by depositing money in a bank and earn 5% and you can borrow from the bank at 7%.
The difference between the 7% borrowing and 5% saving is the cost of financial
intermediation; the 2% difference between the savings rate which is a cost to the bank and the

49
An arguably even more interesting or rather a more challenging point to conventional economic thinking in
advanced industrialised countries such as the US and Australia is that China’s unprecedented (at least for a large
country) persistent rate of high growth came about via highly centralised planning system that many orthodox
economists in the US, Western Europe and Australia would have predicted would fail. For a useful perspective
on these matters I recommend, Cambridge economist, Ha-Joon Chang’s book 23 Things they don’t tell you
about Capitalism”. Professor Chang, a South Korean, is a proponent of heterodox economic theory, which
refers to all economic theories that are not market based.
50
“The growth of finance" (2013) by Robin Greenwood and David Scharfstein Journal of Economic Perspectives
v27(2):3-28.

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7% rate which is revenue for the bank pays for the bank’s operating costs and also covers its
profits. We can say that the cost of intermediation is 2%.
What financial economist Thomas Philippon has found for the US market, which seems to hold
true in countries such as Australia, is that the cost of intermediation, i.e. 2%, does not appear
to have changed since the early part of the 19th century.51 That is, despite improvements in
technology and more developed financial markets there has been no increase in the efficiency
of financial intermediaries. There also do not appear to be significant economies of scale so
that having much larger financial institutions does not generate improvements in efficiency.
The result is that as the finance sector grows in both absolute and relative terms, it captures a
larger share of the value of economic output.
From the perspective of someone entering finance this is a good news story. If finance
continues at the same level of efficiency whilst demand for financial services increases then it
will continue to be a lucrative sector to work in. Of course, the rest of society is not enchanted
by this prospect since the greater the share of economic output captured by finance the less
there is for other sectors.
If the presence of a large finance sector was clearly associated with a more active, vigorous
economy people would be less concerned. Unfortunately, the evidence is ambiguous. There
does not appear to a clear link between the growth of some parts of the finance sector and
economic output. On the contrary, there is a view that finance has become over-developed so
that rather helping people manage risk more effectively, some products are leading people to
take on more risk than they can afford. (more on this when we discuss the global financial
crisis). As financial economists Robin Greenwood and David Scharfstein say:
“While greater access to credit has arguably improved the ability of households to smooth
consumption, it has also made it easier for many households to overinvest in housing and
consume in excess of sustainable levels. This increase in credit was facilitated by the growth
of “shadow banking,” whereby many different types of nonbank fifi nancial entities
performed some of the essential functions of traditional banking, but in a less-stable way.
The fifi nancial crisis that erupted late in 2007 and proved so costly to the economy was
largely a crisis in shadow banking” (p.6).52
We address the above point in more depth when we review financial crises later in the semester.
To summarise: Since the start of the last century, finance has affected more sectors of the
economy in industrialised advanced economies. This has drawn more people into finance but
the efficiency of finance has not improved so that, in effect, demand for finance has increased
but the price has remained the same. This has caused finance to capture a larger share of total
economic profit. This phenomenon is puzzling from a standard economics perspective.
Normally, advances in technology and greater competition will result in greater efficiencies.
To quote Thomas Philiippon:
"Despite its fast computers and credit derivatives, the current financial system does not
seem better at transferring funds from savers to borrowers than the financial system of 1910.

51
"Finance vs. Walmart: Why are Financial services so Expensive?" by Thomas Philippon in Rethinking
Finance A. Blinder, A. Lo and R. Solow (eds) (2012); See also, "Has the US finance industry become less
efficient? On the theory and measurement of financial intermediation" by Thomas Philippon American
Economic Review 105, no. 4 (2015): 1408-38. For the international evidence, see “An international look at the
growth of modern finance” (2013) by Thomas Philippon and Ariell Reshef Journal of Economic Perspectives
v27(2):73-96.
52
“The growth of finance" (2013) by Robin Greenwood and David Scharfstein Journal of Economic
Perspectives v27(2):3-28.

Page 19 of 31
 … Why did we get the bloated finance industry of today instead of [something similar to]
the lean and efficient Wal-Mart?"53
We now turn to look at the impact of technology on the profitability of finance; first from a
specific oompany perspective and then from the perspective of the whole finance sector.
Technology
Afterpay relies substantially on leading technology to review customers’ creditworthiness and
track then their subsequent record in repaying their debts. The technology is both the basis of
the company’s competitive advantage and a potential weakness if competitors come up with
better, more capable technology. The point here is that in considering the future profitability
of the company, Afterpay’s management (and investors) need to assess the company’s ability
to manage its technological challenges.
In July 2019, two Goldman Sach analysts, Ashwini Chandra and Grace Fulton, provided a
useful review of three technological innovation challenges Afterpay faces.54 The first is to
improve its capabilities in accurately assessing shoppers’ creditworthiness and potential for
fraud. The second innovation challenge is to provide add-on services for customers and
merchants such as, for examples, rewards or loyalty programs, tailored marketing, and pricing
and inventory services (to help merchants with stock clearances). The third innovation
challenge is to add technological capability for more flexibility around shopper payments –
giving shoppers more options about time to pay, or how much they have to pay upfront.
The Goldman Sachs analysts noted that the above technological innovations are necessary for
Afterpay to compete effectively against competitors such as US company “Affirm” and
Swedish headquartered “Klarna”.
Afterpay’s competitive landscape shows the curious phenomenon in finance: improvements in
technology do result in greater efficiency but they also spur an increase in the demand for
finance. As financial reporter Misa Han has noted:
“Buy-now, pay-later players are propping up the weak retail sector, with the latest estimate
from UBS suggesting the payment channel makes up more than half of online sales for some
retailers”55
There’s no doubt that Afterpay has helped increase spending but is the increase in consumer
spending sustainable or beneficial to them? We can draw an analogy with telephones.
Improvements in technology have greatly increased the efficiency of making a phone call and
lowered the per unit cost of a call. Technological advances have also made it easier to do other
things on the phone as well. All this has resulted in people spending more time than ever before
on their phones and the question is whether this is good for them.
The relationship between technology and demand for financial sector services has relevant
implications for young graduates entering the finance sector. The typical concern is that
technology will take over the things that people do in the industry. For example, many bank
tellers have been replaced by automatic teller machines (ATMs). However, the relationship
between technology advances and demand for human labour is more complex than simple
substitution. There are now more jobs in the world than ever before even though machines are

53
"Finance vs. Walmart: Why are Financial services so Expensive?" (2012) by Thomas Philippon, Rethinking
Finance A. Blinder, A. Lo and R. Solow (eds).
54
The summary that follows is based on this report: "Afterpay's next growth challenge: Goldman Sachs argues
Afterpay will need to innovate to ensure it remains competitive in the tough US market" Chanticleer column
Australian Financial Review 10 July 2019
55
"Afterpay, Zip propping up sluggish retail sales" by Misa Han Australian Financial Review 4 June 2019

Page 20 of 31
becoming more capable. In general terms, advances in technology may displace jobs as the
first order effect but the second order effect is to increase the demand for human labour.
The example of ATMs neatly illustrates what is going on and the implications for graduates
wanting to position themselves favourably in the labour market. US legal academic James
Bessen specialises in workplace automation. This is what he found in connection with ATMs:
“Automated teller machines (ATMs) were first installed in the United States and other
developed economies in the 1970s. These machines handle some of the most com- mon tasks
bank tellers performed, such as dispensing cash and taking deposits. Starting in the mid-
1990s, banks rapidly increased their use of ATMs; over 400,000 are installed in the United
States alone today.
One might expect such automation to decimate the ranks of bank tellers, but in fact the
number of bank teller jobs did not decrease as the ATMs were rolled out ... Instead, two
factors combined to preserve teller jobs.
First, ATMs increased the demand for tellers because they reduced the cost of operating a
bank branch. Thanks to the ATM, the number of tellers required to operate a branch office
in the average urban market fell from 20 to 13 between 1988 and 2004. But banks responded
by opening more branches to compete for greater market share. Bank branches in urban
areas increased 43 percent. Fewer tellers were required for each branch, but more branches
meant that teller jobs did not disappear.
Second, while ATMs automated some tasks, the remaining tasks that were not automated
became more valuable. As banks pushed to increase their market shares, tellers became an
important part of the “relationship banking team.” Many bank customers’ needs cannot be
handled by machines—particularly small business customers’. Tellers who form a personal
relationship with these customers can help sell them on high-margin financial services and
products. The skills of the teller changed: cash handling became less important and human
interaction more important”.56
To make clear the implications for finance graduates: it is likely that you will read, every now
and then, reports of mass retrenchments in the banking sector. This doesn’t necessarily imply
that the total number of jobs in the sector is decreasing but more likely implies that the mix of
skills required in the sector is changing. You need to keep up with the technology but also
identify the new skills that are going to be at a premium. As the ATM example shows, the
relationship side of banking is likely to increase rather than decrease in importance with
automation. What you can be confident about is that the work of a banker in, say, 15 years time
is going to be different in significant respects from the work of banker today.
Regulation
There is no such thing as a “free market”. All markets are regulated. There are however good
and bad regulations, in the sense that “good” regulations promote desirable market outcomes
and “bad” regulations do not. The analysis of regulations is fascinating (I am not being
sarcastic, I really do find it interesting!) but there’s no scope to go into that here. For now, I
just make the point that lobbying the government or other relevant regulatory authorities to
change the “rules of the game” to give particular companies or industries a competitive
advantage is a pervasive element of modern economies.
For example, on 20 January 2020, under the headline “Afterpay’s plea for regulatory support”
the Australian Financial Review reported:

56
"Toil and Technology" (2015) by James Bessen Finance & Technology - Journal of the International
Monetary Fund v52(1)

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 “Afterpay shares were hammered in the second half of 2018 due to uncertainty about
whether responsible lending laws would be extended to its model, which would require it to
conduct more extensive checks on prospective customers”. 57
Reporter James Eyers noted that Afterpay’s business model has drawn attention from other
providers of financial services, particularly credit card companies, because the fact that it
doesn’t charge interest means that it doesn’t fall under scope of existing credit card laws and
arguably faces lower compliance costs. Critics, some of whom include companies offering
consumer credit and therefore anxious to protect their market, say that it is not reasonable that
Afterpay is effectively unregulated by credit laws.
Here’s an example of the critics’ argument:
“It’s like the wild west,” says Julia Davis, of the Financial Rights Legal Centre. Because
companies like Afterpay don’t charge interest on purchases – just late fees if users fail to
pay on time – they aren’t required to screen applicants the way traditional credit companies
are, or subject to the same level of government scrutiny.
“They don’t need to check that you can actually afford to pay back these debts before they
give you the credit,” Davis says. “They squeeze into a loophole in the law – they’re not
considered a credit provider, so they don’t need a licence. But they’re certainly encouraging
people to spend money they don’t have. Even if it’s not considered credit under the law, it’s
absolutely a debt”
I’m not trying to say buy now pay later is an evil product, it’s just a new product. And it’s
not licensed”.58
The argument offered by Afterpay against regulation is that the regulators should not just look
to see whether a financial services entity is covered under existing laws but see whether overall
its business model furthers the interests of consumers.
Afterpay, whose business model has faced heavy scrutiny given it does not trigger existing
credit laws because its customers are not charged interest, wants regulators to give new models
the benefit of the doubt. Some of the popularity of Afterpay is precisely that it is not a credit
card company that allows its customers to rack up large debts. As a not famous finance expert
is quoted as saying in The Guardian:

“That’s the appeal of something like Afterpay: although it’s quite a big company now, it
doesn’t have the stigma attached to a large credit card company,” says Raymond Da Silva
Rosa, a finance professor at the University of Western Australia. … Generally, Da Silva
Rosa believes that buy now pay later services are “less risky as a whole” than credit cards,
partly because their loan limits are much lower – Afterpay’s current cap is $2,000, a sum
reached only after the user has demonstrated their ability to repay on time”.59

The debate over regulation of Afterpay illustrates two ongoing challenges in regulating
financial markets. One is the issue about how much freedom people should have to make
decisions for themselves. In general, the Anglo-Saxon tradition (i.e., the customs of the part
of the world influenced by English culture, which includes the US, Australia and many

57
"Afterpay's plea for regulatory support" by James Eyers Australian Financial Review 20 January 2020
58
‘It’s like the wild west’: is the latest buy now pay later service just rebranded debt?” by Katie Cunningham The
Guardian 8 February 2020
59
‘It’s like the wild west’: is the latest buy now pay later service just rebranded debt?” by Katie Cunningham The
Guardian 8 February 2020

Page 22 of 31
commonwealth countries which were former colonies of the UK)60 reflects the liberal (in terms
of philosophy, not current Australia political party) view that “each person is the best judge of
their own interests”61. This creates a tension when people propose that some freedoms should
be curtailed. For example, the Guardian article “It’s like the wild west ….” that was quoted
earlier also reports what Julia Davis of the Financial Legal Rights Centre has witnessed:
“Davis has seen people with no income and no ability to repay their purchases be approved
for buy now pay later services. She says some customers have multiple accounts across
different providers, making their debts hard to keep track of. The Financial Rights Legal
Centre is currently working with a woman, in debt for 35 different purchases made with a
buy now pay later service, who was able to keep shopping long after she should have been
cut off”.62

The question here is: at what point do we take away people’s right to decide how much debt
they may take on? More particularly, is it the responsibility of Afterpay to ensure that someone
doesn’t succeed in deliberately avoiding the rules for responsible borrowing? I return to this
question in the section section on ethics in finance.

The other challenge with regulation is that it can stifle innovation, which is usually not the
intend of the regulators but an unfortunate negative by-product. Particular regulation is
generally designed with current technology in mind. For instance, we have speed limits
because our current technology does not allow us to have self-driving cars that can move us
safely at much higher speeds. If the regulations are not relaxed when new technology emerges
then the introduction of innovative faster and safer cars will be stifled. As this example shows,
the argument that regulation restricts innovation is general and not restricted to finance but now
I will show its relevance to finance.
Two remarkable aspects of modern consumer finance are how backward the US is in many
respect and how much more advanced is China. For instance, in the US it is still uncommon
to use contactless credit when purchasing items as the following recent report shows:
“Compared with China, India and other parts of the world, the U.S. is way behind in
adopting mobile payments.
It seems odd considering the ubiquity of smartphones in America. But experts say a deeply
embedded legacy system and rewards cards, among other factors, make it unlikely that we’ll
see a major shift anytime soon”63
As the quote indicates, it is not just regulations that prevent the US from adoption of modern
technology in its payments system, however, as the following point from a paper about US
financial regulation indicates, regulation is a significant barrier to innovation:

60
As a matter of interest, approaches to financial markets vary considerably even in modern industrialised
countries. For instance, the regulatory approach to, and consequently structure of, financial markets in Germany,
France and Japan is quite different to that prevailing in the US, UK, Australia and Canada. The global financial
crisis resulted in the prestige and regard of the Anglo-Saxon model being significantly damaged. We shall return
to this point later in the semester.
61
The most prominent champion of this view is the 19th century English philosopher and economist John Stuart
Mill, whose arguably most famous work is “On liberty” (1859). Modern western society is very heavily
influenced by Mill. Many individual freedoms we have are due to his views being widely accepted.
62
‘It’s like the wild west’: is the latest buy now pay later service just rebranded debt?” by Katie Cunningham
The Guardian 8 February 2020
63
"Mobile payments have barely caught on in the US, despite the rise of smartphones" by Kate Rooney CNBC
news AUG 29 2019 https://www.cnbc.com/2019/08/29/why-mobile-payments-have-barely-caught-on-in-the-
us.html

Page 23 of 31
 “… public goal of inclusive finance is impeded by policy that creates high regulatory risks
and costs for providers that are seeking to serve lower-income and other vulnerable
consumers, partly due to high levels of uncertainty about permissible product design and
pricing. This discourages banks, in particular, from even attempting to serve these markets,
thereby reducing competition and leaving the people who need the most protection
consigned to the least-regulated markets (which also tend to attract less scrupulous
providers).”64
The reason China and developing countries such as India are able to adopt innovative finance
technology so easily is that there is no prior substantial regulatory structure to impede adoption.
The Chinese government has been content to allow a wide variety of innovative payment
methods to be used in China. The result is:
“…the Middle Kingdom is far more advanced than just about any other nation when it comes
to financial tech. "If you want to see the future of fintech, just go to China," said Edith Yeung,
managing partner of Proof of Capital, a blockchain-focused investment firm. She cited
Alibaba-spinoff Ant Financial and Tencent's WeChat as paragons of digital banking and
payments.”65
If you have visited China recently (difficult to do during the pandemic) or know someone who
has I think you will find that the above statement is apparent even after a short time there. It’s
also worth noting that the Chinese government doesn’t adopt a laissez faire (i.e., anything goes)
approach to financial regulation. It has banned privately issued cryptocurrencies, their mining
and initial coin offerings, perhaps because it intends to issue its own cryptocurrency.66
My purpose here is not enter a debate into the relative merits of the US and Chinese approaches
to financial regulation (although it is a very interesting topic) but rather to use their respective
approaches to illustrate that regulation makes a difference to the vitality of the financial sector.
Indeed, one thing that stands out from the best available research is that less regulation tends
to go with a more robust financial sector and one that delivers higher pay to those in the sector.67
A summary of this research by one of the authors, eminent French financial economist, Thomas
Philippon, is available in Recommended Readings for Week 1 under the title “Are Bankers
Paid Too Much”. The following paragraph conveys the principal finding:
“Our investigation reveals a very tight link between deregulation and human capital in the
financial sector. Highly skilled labour left the financial sector in the wake of Depression
era regulations, and started flowing back precisely when these regulations were removed.
This link holds both for finance as a whole, as well as for subsectors within finance. Along
with our relative complexity indices, this suggests that regulation inhibits the ability to
exploit the creativity and innovation of educated and skilled workers. Deregulation
unleashes creativity and innovation and increases demand for skilled workers”.
The hypothesis implicit in Philippon and Reshef’s explanation is that when regulations are
relaxed then finance workers are free to design and sell new financial products and services
that service a previously unmet need. The concern is whether these novel financial products

64
“Regulation Innovation: Using Digital Technology to Protect and Benefit Financial Consumers" by Jo Ann
Barefoot. M-RCBG Associate Working Paper Series no 110 Harvard Kennedy School March 2019

65
"China's Fintech Revolution - The Ledger" by Robert Hackett Fortune magazine 13 August 2019
66
"Why China Has Made The Right Call On Cryptocurrencies" by Enrique Dans Forbes magazine 14 April
2019
67
"Wages and human capital in the US finance industry: 1909–2006" (2012) by Thomas Philippon,and Ariell
Reshef. Quarterly Journal of Economics v127(4): 1551-1609.

Page 24 of 31
and services create value or are simply ways for financiers to appropriate more value for
themselves at the expense of others.
This is an important question to which we don’t have a conclusive answer. Most mainstream
economists agree that the financial sector creates value, for the reasons discussed earlier in this
chapter, but they are not confident all financial transactions are socially productive. Perhaps
surprisingly, this doubt about the value of some finance activities is shared by eminent
economists. In an article headed “Should we worry about 'unproductive' financial sector
gobbling up our best?” the Nobel Prize winning economist Robert Shiller has observed that:
“economic research has not yet permitted us to estimate the value to society of so many of our
best and brightest making their careers in the currently popular kinds of "other finance".68
This is a remarkable observation about the largest section of the economy but that’s the state
of our understanding today.
Summary: why is finance profitable and will it remain so?
Economic advances tend to increase the demand for financial intermediation. This demand is
also facilitated by improvements in technology and by light regulation both of which foster
innovative financial products and services. In a way similar to the impact of smart phones on
people’s time on their devices, improvements in financial services seem to drive up demand
and the sector’s share of total economic value has increased. People who develop skills and
competencies that are required to operate the prevailing financial technology are likely to
continue to earn above average pay.

Why is finance often ethically challenging?

Context
Two years ago, in February 2019, The Honourable Kenneth Madison Hayne AC QC submitted
to the Governor-General of Australia the final report from the Royal Commission into
Misconduct in the Banking, Superannuation and Financial Services Industry. The first page of
the report stated:
“The conduct identified and described in the Commission’s Interim Report and the further
conduct identified and described in this Report includes conduct by many entities that has
taken place over many years causing substantial loss to many customers but yielding
substantial profit to the entities concerned.
Very often, the conduct has broken the law. And if it has not broken the law, the conduct has
fallen short of the kind of behaviour the community not only expects of financial services
entities but is also entitled to expect of them.”
The findings from the Royal Commission were a welcome outcome for many people who have
long believed the conduct of the financial services industry has fall far below acceptable
standards. Other people, who defended the banks and believed that the Royal Commission was
unnecessary were surprised and (mostly) admitted they were wrong. For instance, News
Corporation financial reporter Terry McCrann wrote in August 2017 that the country was:
“…tumbling inexorably towards a (completely unnecessary, politically cynical, stupid and
potentially harmful) royal commission”. It was “not quite a royal commission about

68
“Should we worry about 'unproductive' financial sector gobbling up our best?” by Robert Shiller The Guardian
23 September 2013.

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 nothing; just a royal commission about nothing that we don’t already know”, he later
said.”69
Mr McCrann subsequently recanted, saying:
“I have to confess to being … very surprised and very, very impressed. Commissioner
Kenneth Hayne has delivered a very nuanced and sophisticated — and most importantly,
effective — report and set of recommendations,” McCrann said.
“I am more than happy to say I was wrong in arguing against having this royal commission.
But thanks only to Hayne.”
The public hearings of the Royal Commission made for gripping viewing and a few top banking
executives lost their jobs as a result. What kind of bad conduct did the banks engage in? Here’s
a small sample from the ABC News of 19 April 2018:
“Yes, the evidence at the royal commission has been explosive, with AMP admitting it lied
to the corporate watchdog ASIC on 20 separate occasions and also admitting it charged
fees to its customers for services they did not receive.
Commonwealth Bank confessed it was guilty of doing the same, and agreed it was a gold
medallist in the sport of ripping off its clients.
And then came the revelation that the bank had knowingly ripped off the dead:
Kisten Aiken: So far, the commission has heard from Commonwealth Bank executive
Marianne Perkovic, who has admitted the bank charged fees to clients they knew had
died.”70
Charging fees for services one did not provide is often referred to as theft.
A systemic ethical problem in financial services?
Perhaps the truly disturbing aspect of the financial scandals that the Hayne Royal Commission
exposed is that they were not an isolated case. This is not just an instance of one country’s
banking system exhibiting an unusual period of bad behaviour. The kind of unethical practices
that Hayne uncovered are remarkably common in major industrialised economies. For instance,
over the two-year period 2012 to 2014, the fines paid by financial institutions to US law
enforcement agencies came to a total of $138 billion71. In Australia, the Commonwealth Bank
agreed in June 2018 to pay a fine of $700 million for failing to report suspicious deposits,
transfers and accounts.72 This was the fine just for one kind of offence.
There seems to be something about the finance sector that promotes unethical behaviour. This
unsavoury connection has long been recognised historically. For instance, at least three major
religions, Judaism, Christianity, and Islam (the three so-called “Abrahamic” faiths because a
central figure in all three religions is the patriarch Abraham) frown on money-lending. A
famous verse in the Bible says

69
McCrann’s comments reported in: “Singing a different tune: the journalists who changed their minds on the
royal commission” by Rod Meyer Crikey.Com 7 February 2019
https://www.crikey.com.au/2019/02/07/banking-royal-commission-journalists/
70
https://www.abc.net.au/mediawatch/episodes/royal-commission-backtrack/9972270
71
"Presidential address: Does finance benefit society?" (2015) by Luigi Zingales Journal of Finance v70(4):
1327-1363.
72
“Commonwealth Bank to pay $700m fine for anti-money laundering, terror financing law breaches” ABC
News 4 Jun 2018, 9https://www.abc.net.au/news/2018-06-04/commonwealth-bank-pay-$700-million-fine-
money-laundering-breach/9831064

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 “For the love of money is the root of all evil: which while some coveted after, they have
erred from the faith, and pierced themselves through with many sorrows” (First letter of St
Paul to Timothy, Ch. 6 verse 10).
Regrettably, the corporate culture in banks seems to promote this behaviour. A study published
in Nature (arguably the world’s most prestigious research journal) titled “Business culture and
dishonesty in the banking industry” reported findings that showed:
“… employees of a large, international bank behave, on average, honestly … However,
when their professional identity as bank employees is rendered salient, a significant
proportion of them become dishonest. This effect is specific to bank employees … Our
results thus suggest that the prevailing business culture in the banking industry weakens
and undermines the honesty norm”.73
Note that the findings from the above research are consistent with the findings from the Royal
Commission.
Chapter two of the CFA Institute's Investment Foundations program is "Ethics and Investment
Professionalism" (by Gerard Hambusch, CFA).74 It includes the following paragraph:
"In 2013, a study by CFA Institute and Edelman examined trust by investors in investment
managers and explored the dimensions that influence that level of trust.1 The study found
that only about half of the surveyed investors trust investment managers to act ethically.
This result is troubling. As Alan M. Meder, CFA, former chair of the CFA Institute Board
of Governors, put it earlier, “A tarnished reputation is difficult to clean. . . . The
investment profession is built on trust as much as it relies on expertise.”" (emphasis in
bold added)75
How valid is the above statement? Is it really difficult to recover from a tarnished reputation?
It’s difficult to imagine a more public and humiliating tarnishing of public reputation than that
suffered by Australian banks as a result of the Hayne Royal Commission and the fines they
have had to pay yet, as the following headline report shows, the banks have recovered
remarkably well. On 20 December 2019 the Chanticleer column in the Australian Financial
Review noted the following comment under the headline “Why CBA is back on top”:
“Two years after it was hammered by AUSTRAC for failures in its anti-money laundering
systems, Commonwealth Bank of Australia is leading the banking pack again.
After another tumultuous year in banking, it is obvious Commonwealth Bank of Australia is
not only the best bank in the country, it is in little danger of losing this mantle to any of its
three smaller rivals any time soon”.76
Intellectual challenge: reconciling benefits of banking with systematic unethical conduct
A quote often attributed to the eminent economist John Maynard Keynes is:

73
“Business culture and dishonesty in the banking industry” (2014) by Alain Cohn, Ernst Fehr & Michel André
Maréchal Nature v516: 86–89
74
The CFA Institute is dedicated to supporting investment professionals through an education program,
amongst other things. https://www.cfainstitute.org/en
75
"Ethics and investment professionalism" by Gerhard Hambusch, CFA, Chapter two in the CFA Institute
Investment Foundations® Program Curriculum ttps://www.cfainstitute.org/-
/media/documents/support/programs/investment-foundations/2-ethics-and-investment-
professionalism.ashx?la=en&hash=A41F6946B0948C3CB0A858707BB078A41FB3E6DC
76
“Why CBA is back on top” Chanticleer Australian Financial Review 20 December 2019.

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 “Capitalism is the astounding belief that the most wickedest of men will do the most
wickedest of things for the greatest good of everyone”77
The quote seems inspired by the famous passage from Adam Smith’s An Inquiry into the
Nature and Causes of the Wealth of Nations vol 1 (1776):
“It is not from the benevolence of the butcher, the brewer, or the baker that we expect our
dinner, but from their regard to their own self-interest. We address ourselves not to their
humanity but to their self-love, and never talk to them of our own necessities, but of their
advantages”
The intellectual challenge that the reports of misconduct in the banking sector present is this:
how do we explain the various positive benefits from financial services (discussed earlier) with
the extensive scale of unethical behaviour in the sector? No one is forced to buy financial
services so how does the finance sector survive and even thrive in the face of seemingly
systematic misconduct?78
The economics discipline does not have a well-developed theory of middleman, even though
many professionals are essentially intermediaries. One consequence is that economics has very
little to say about exploitation by middlemen. The general assumptions are that people will be
smart enough to recognize when they are likely to be exploited and will avoid such a situation
and if they are exploited then there will be sufficient competition amongst middlemen so that
unethical behaviour will be punished by clients refusing to do business with the exploitative
intermediary. This model of how the world works has the consequence that many people
sympathetic to the idea of market economies find it difficult to acknowledge that there may be
a significant problem with unethical behaviour; they tend to dismiss individual instances as
being unrepresentative of the market or isolated cases. This is my explanation for why many
eminent commentators did not initially support the setting up of the Hayne Royal
Commission.79
In practice, things are not that simple, many people do not even recognise when they have been
exploited by an intermediary in whom they trusted. The clients who are exploited are not
necessarily naïve or unintelligent: the risk of being exploited is inherent in using a middleman.
Middlemen exist because people lack all the information they need to make an optimal
decision. For example, the reason you buy the services of a financial adviser is precisely
because you have less information that they do to make the best decision. When we use a
middleman, we have to trust they are acting in our best interests. This leaves us open to
exploitation.
Even when people recognise or are given evidence of systematic exploitation they may not be
able to take their business elsewhere. In this respect, large financial services institutions in
Australia (and elsewhere) enjoy significant advantages, partly as a result of government policy,
which have the consequence that they can get away with unethical behaviour that would
otherwise be penalised in more competitive markets.80

77
There’s no evidence that Keynes actually said or wrote this statement but perhaps he may have wished he had
and probably wouldn’t mind it being attributed to him.
78
Having referenced Adam Smith, it’s worth noting that he was not naïve and had a very sharp understanding of
the motives of business people. Further, he emphatically did not promote unethical behaviour nor did his
arguments imply that unethical behaviour promoted good outcomes for everyone one.
79
As noted earlier, many, changed their minds and said so, to their credit, after the Commission reported its
findings. See “Royal Commission backtrack” https://www.abc.net.au/mediawatch/episodes/royal-commission-
backtrack/9972270.
80
Australia’s Productivity Commission has noted that the big four banks get significant support from the so-called
“four pillars’ policy, as the following news report notes:

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A useful analytical framework to discuss ethical misconduct by intermediaries
To get the appropriate analytical concepts to be able to discuss ethical misconduct by
intermediaries in a sensible or useful way, we have to go outside the discipline of economics.
In her book The Middleman Economy (discussed earlier), Marina Krakovsky adapts a model
developed by sociologists Susan Fiske, Amy Cuddy and Peter Glick to identify four categories
of intermediaries. Krakovsky classifies intermediaries on the basis of two attributes: “warmth”
(on the vertical axis) and “competence” (on the horizontal axis). Warmth refers to
consideration of the client’s interests, such that intermediaries that rate high on warmth are
always mindful of what’s in the best interests of their clients. Competence refers to how good
the intermediaries are at their work. Sorting on the basis of warmth and competence generates
four classifications of intermediaries (see figure 1 at end of chapter):
1. Partners - experts who create value for themselves and their clients (competent, warm)
2. Predators - experts who capture disproportionate gain (competent, cold)
3. Pets - non-experts who mean well (incompetent, warm)
4. Parasites – non-experts who gain without adding value (incompetent, cold)81
In practice, i.e., in actual markets, middlemen don’t fall entirely into one category. There will
be some transactions in which a middleman will be a partner, others in which they will be a
predator and yet others where they will exhibit the behaviour of a pet or parasite. We can hope
that in the majority of transactions they will act as a partner.
I have taken examples from the Hayne Royal Commission to show examples of major
Australian financial institutions exhibiting the above characteristics.
Partner: When the Commonwealth Bank (CBA), NAB, Westpac and ANZ lend money for
housing mortgages or when they make business loans, they are typically creating value for both
themselves and the borrowers. Both parties are better off as a result of the transaction. This is
partner behaviour but it can be difficult to judge. Some people may say that the banks will
sometimes lend more money than the borrowers can afford to repay. It is difficult to judge. At
what point do we say the banks are better judges of their clients’ interests than the clients
themselves?
Predator: The Hayne Commission showed that CBA, Westpac, NAB and ANZ provided
incentives to agents to sell financial products not in their clients’ best interest:
“ … evidence … showed that even if doing business in a particular way was of actual or
possible disadvantage to customers, the banks would not alter that way of doing business if
unilateral change would bring significant competitive disadvantage” (Hayne, 2018 v1, p.
68).82

"While protecting competition may have been the stated objective of the four pillars policy, in practice it has
protected a specific market structure above all else — one dominated by four domestic banks," the draft report
[from the Productivity Commission] said."It has thus had the scope to weaken the four major banks’ ability to
pose a credible competitive threat to each other."
Source: "'Four pillars' policy under fire from Productivity Commission" by Clancy Yeates Sydney Morning
Herald 7 February 2018https://www.smh.com.au/business/banking-and-finance/four-pillars-policy-under-fire-
from-productivity-commission-20180206-p4yzio.html
81
Source: The Middleman Economy: How Brokers, Agents, Dealers, and Everyday Matchmakers Create Value
and Profit by Marina Krakowsky (2015, pp. 8-13) based on a model developed by Susan Fiske, Amy Cuddy &
Peter Glick 2007 "Universal dimensions of social cognition: warmth and competence" TRENDS in Cognitive
Science v11(2):77-81.
82
Interim Report: Royal Commission into Misconduct in the Banking, Superannuation and Financial Services
Industry (2018) Commonwealth of Australia

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Parasite: The Hayne Commission also showed that the major financial institutions were
incompetent in aspects of their work and failed to deliver what they promised yet still charged
fees:
(a) “the four largest banks and AMP all acknowledged in their initial submissions to the
Commission that they or their associated entities had charged clients fees for personal
financial advice that had not been provided” (Hayne, 2018 v1, p. 123)83
(b) “the case studies revealed numerous cases where banks charged fees or interest in
amounts larger than agreed because of what were called ‘processing’ or ‘administrative’
errors … Mistakes in enterprises as large as a bank are inevitable. [Three points] First,
entities should not offer to sell what they cannot deliver. … Second, the entity that sells a
product should have adequate systems in place before the first sale is made. … The third,
and equally simple, observation to make is that, if an entity does not deliver what it has sold,
the entity must remedy that default and the consequences of the default as soon as is
reasonably practicable” (Hayne, 2019 v1, p. 112/3).84
Pet: Pet-like behaviour is where an intermediary means well and really has the interest of the
client at heart but is too incompetent or otherwise unable to deliver. I couldn’t find an example
of pet-like behaviour from the major banks but some credit unions, which are small financial
cooperatives, may arguably be classified as “pets” because they are high in warmth: “Credit
unions see themselves as different from mainstream banks, with a mission to be "community-
oriented" and "serve people, not profit” (Wikipedia). However, credit units may not have
sufficient economics of scale to get sufficient credit at low cost for their members.
As noted, it can be difficult to identify the categories. Was CBA engaged in predatory
behaviour or was it exhibiting partner behaviour when it offered a client, Mr Harris, more credit
when he applied for it after he had informed the bank of his gambling problem? (Hayne, 2018
v1, p. 53).
Figure 185
Value-Adding Categories of Intermediaries

Pet Partner
Warmth

Parasite Predator

Competence
83
Interim Report: Royal Commission into Misconduct in the Banking, Superannuation and Financial Services
Industry (2018) Commonwealth of Australia
84
Final Report: Royal Commission into Misconduct in the Banking, Superannuation and Financial Services
Industry (2019) Commonwealth of Australia
85
Source: The Middleman Economy: How Brokers, Agents, Dealers, and Everyday Matchmakers Create Value
and Profit by Marina Krakowsky (2015, pp. 8-13)

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Concluding comments on ethics
Financial markets have moral dimensions that are substantial and complex. FINA3324 doesn’t
give the moral dimension of finance the attention it deserves. The aim of this section is to make
you somewhat aware of the moral dimension of finance and its complexity. You have a choice
whether you wish to be a partner, predator, parasite or pet.

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